Sec. 121 Exclusion of Gain from Sale of a Principal Residence

For generations, citizens and
residents of the United States have pursued the
American dream of home ownership. While purchasing
a first home is a milestone in the lives of many
Americans, meeting the changing needs of their
families, relocations necessitated by employment,
or any number of factors may compel them to buy
and sell one or more principal residences over the
course of their lives. As a result of changing
market prices, taxpayers may realize gains or
losses on the sale of their homes. Whereas losses
realized on the sale of personal residences are
treated as nondeductible personal losses, gains
realized on those sales may be subject to income
tax. Prior to 1951, any gain from the sale of a
personal residence was taxed as a capital gain.
The result of this policy was that taxpayers were
left with reduced proceeds to reinvest in their
replacement homes.

Recognizing that this
caused hardship for many homeowners, particularly
for those taxpayers who may have been forced to
sell and relocate for reasons beyond their
control, Congress granted relief from the capital
gain provisions with the Revenue Act of 1951, P.L.
183, 82d Cong. (65 Stat. 452). As originally
enacted, the relevant sections of the 1951 act
generally provided for the deferral of gain
recognized on the sale of a principal residence if
a taxpayer purchased a replacement residence of
equal or greater value. There have been many
changes to these provisions since 1951 that have
led to the current tax regime. Under current law,
Sec. 121 provides that taxpayers may exclude up to
$250,000 ($500,000 for joint returns) from the
gain on the sale or exchange of a principal
residence provided they meet certain ownership and
use requirements.

This past summer, the Tax
Court took up a discussion of Congress’s intent
for Sec. 121 when it decided the case of Gates, 135 T.C.
No. 1 (2010). In the stipulated facts of that
case, the Gateses owned and used a house as their
principal residence, satisfying both the ownership
and use requirements of Sec. 121. In 1999, they
began remodeling that house but, due to
complications of retrofitting it to comply with
the building code, the remodel morphed into a
complete teardown of the structure and the
construction of an entirely new house on the same
site. Without having resided in the new house, the
Gateses sold the new house along with the land it
was built on in 2000, realizing a gain on the sale
of $591,406. Ultimately, the Gateses reported the
$91,406 gain in excess of $500,000 on their
untimely filed 2000 income tax return, claiming
that the remaining $500,000 gain was excludible
under the provisions of Sec. 121. Upon examination
of the Gateses’ return, the IRS disallowed the
exclusion and issued the taxpayers a notice of
deficiency. In its July 2010 decision, the Tax
Court sided with the IRS.

Property Sold as a Principal
Residence

In the parts relevant to this
case, Sec. 121(a) explicitly states that for the
taxpayer to exclude any gain from gross income
under that section, the property sold must have
been the taxpayer’s principal residence. At issue
in the Gates case are
the definitions of “property” and “principal
residence.” The Gateses’ position was that the
property serving as their principal residence was
the land and the dwelling on it, while the IRS’s
position was that the property serving as the
principal residence was the dwelling. Sec. 121
does not define these terms, so the court sought
to determine congressional intent to decide
whether Sec. 121 should apply to the land, the
dwelling structure, or a combination thereof.

The precursor law to Sec. 121 was Sec. 112,
enacted in 1951. Sec. 112 addressed the issue that
taxes on the gain from the sale of a home would
reduce the capital available for purchasing a
replacement home. Sec. 112 provided that no gain
was recognized on the sale of a principal
residence as long as the seller purchased a
replacement principal residence of at least the
same value as the property that was sold within
the prescribed time period. Instead, the gain was
deferred, and taxpayers had the administrative
burden of tracking this deferred gain throughout
their lifetimes. Sec. 112 was later redesignated
as Sec. 1034.

More than a decade later,
Congress enacted Sec. 121 in 1964. In its original
incarnation, Sec. 121 was aimed at older
taxpayers. It allowed for a one-time exclusion of
up to $125,000 of gain on the sale or exchange of
a principal residence if the seller had attained
the age of 55 before the sale and had owned the
property and used it as a principal residence for
three or more of the five years immediately
preceding the sale. This one-time exclusion
applied to one sale, not to one taxpayer.
Therefore, if a taxpayer did not recognize at
least $125,000 of gain on the single sale for
which he or she elected to use the exclusion, any
unused portion of the $125,000 was lost and the
taxpayer could not use it to offset gain on a
later sale. In 1997, Sec. 1034 was repealed and
Sec. 121 was broadened by removing the age
requirement and the one-time limit and increasing
the exclusion amount to $250,000.

All these
amendments furthered the concept of providing
relief to taxpayers selling their homes, but none
addressed the issue of the definition of property
or principal residence. However, in reviewing the
notes from the House Committee on the Budget,
which passed the 1997 amendments, the legislators
used the terms “house” and “home” interchangeably
with the term “principal residence.” The court
found that the contextual usage of “house” and
“home” by the legislators showed that they
intended “principal residence” to refer to the
dwelling structure occupied by the taxpayer. As
the court noted, this position is also consistent
with prior case law generated by questions raised
over the now-repealed Sec. 1034.

Returning
to the facts of the Gates case, the
taxpayers had a home that they both owned and used
for the required two of five years preceding the
sale. If the taxpayers had sold that structure
instead of razing it, it appears that they would
have satisfied the requirements to be eligible to
exclude the gain on the sale as permitted by Sec.
121. However, the Gateses did not sell the home
they had lived in. Instead they sold a newly
constructed house that they never lived in. Having
determined that the term “principal residence” as
used in Sec. 121 pertains to the dwelling
structure and not the land, the court found that
the Gateses failed to meet the use test regarding
the dwelling structure that they sold. They were
therefore required to include the gain on the sale
of the property in their income for the year of
the sale.

Differing
Opinions

While the court’s decision favored
the IRS’s position, it is interesting to note some
of the points brought up in the dissenting
opinion. The dissent suggested plausible scenarios
in which a satisfactory decision might not result
from the majority’s reasoning. In one scenario, a
taxpayer, who otherwise satisfies the ownership
and use tests, tears down a building, leaving the
foundation. The taxpayer then constructs a new
home using the original foundation. Because the
foundation is an integral part of both the new and
the old structures, if the taxpayer sells the
newly constructed dwelling without living in it
for the requisite time period, does he or she meet
the use test? This begs the question of where
remodeling ends and new construction begins.

A second scenario assumes that the primary
residence of a taxpayer is damaged beyond repair
by a circumstance outside his or her control, such
as a hurricane. These circumstances force the
taxpayer to build a new structure. In the process
of designing the new structure, the taxpayer
decides it would be more prudent to locate the new
structure on a different portion of the same tract
of land because that area is more sheltered from
the possibility of future hurricane damage. If the
taxpayer, who satisfied the requirements of Sec.
121 regarding the destroyed house, sells the
replacement house without having lived in it for
the requisite period, should he or she be denied
the favorable tax treatment afforded by Sec. 121?
Under the rule espoused by the majority, these
questions cannot be answered until cases with
similar fact patterns are litigated.

For
the time being, the conclusion of the Gates case
indicates that taxpayers must meet the primary
residence, use, and ownership requirements with
respect to the dwelling structure and not just the
land to satisfy the gain exclusion provisions of
Sec. 121.

EditorNotes

Mark Cook is a partner at Singer Lewak LLP in
Irvine, CA.

For additional information about these
items, contact Mr. Cook at (949) 261-8600, ext.
2143, or mcook@singerlewak.com.

Unless otherwise noted, contributors are
members of or associated with Singer Lewak
LLP.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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